Remember the 1970s

Robert Skidelsky (author of worshipful biographical tomes on Keynes) has a recent article in the Washington Post that is a good example of an emerging historical narrative about the current financial crisis. It goes something like this:

Once upon a time there was a massive economic catastrophe called The Great Depression. It was caused by riotous and unregulated speculation. Wise policy makers, however, learned from their mistakes and they created a heavily regulated financial sector that proved an engine of peace and prosperity until it was destroyed by a malicious group of deregulatory ideologues led by Reagan and Thatcher. Now we are reaping the whirlwind of destruction that comes from forgetting the lessons taught us by FDR and Kaynes in the 1930s.

It’s a nice narrative, particularly at election time, and like all powerful stories it contains a good bit of truth. On the other hand, it leaves out at least one very important chapter: The 1970s.

There is a reason that the West collectively soured on the post-war economic framework created by FDR and his successors. It had a good run, particularly in the United States (although economic dominance of a planet where all of one’s economic rivals had been bombed to smithereens may be less of an accomplishment in retrospect), but in the 1970s it went very badly wrong. The Keynesian dreamland gave way to high inflation, high unemployment, and low growth. New Deal era regulations kept interest rates on bank deposits artificially low, insuring that bankers had access to cheap credit, and the banks in turn were protected from competition by higher yield savings vehicles for depositors. The result was a stable financial system that provided bankers with healthy profits and lots of golf at 4 pm. It only worked, however, by insuring that middle class savings were excluded from investment in the ordinary capital markets, which under FDR’s system were to be a preserve for the wealthy. Rather, the system funnelled main street’s money to the local banker.

Unfortunately, it turned out that inflation was a monetary phenomenon after all. During the 1960s and the 1970s, a politically compliant Fed printed money to fund the New Frontier, the Great Society, and, especially, the Vietnam War for Democratic and Republican administrations that were eager to spend money without the politically unpopular requirement that they extract it from tax payers first. Add in a couple of oil shocks for fun, and suddenly the New Deal financial system is leaving depositors with negative yields on the loans (i.e. checking and savings accounts) that they were making to their local bankers. And so was born the money market account, the eventual deregulation of financial services, and the democratization of investment.

Nostalgia for the New Deal financial system is not a particularly good way of thinking about what sort of regulations we want going forward. Especially if we choose to selectively forget the crisis of that system in the 1970s.

1 Response

Are there a lot of serious people who want to enact New Deal type financial regulations? I’m not completely against it since I make my living parsing those regulations, but I’ve actually been surprised at Congress’ restraint up to this point. Maybe they are waiting for a new President before they get things underway, but from an outsider’s perspective they might just as easily be waiting to see if they can figure out what regulations might actually be useful. SOX went through about eight months after Enron started claiming headlines. The current financial mess has been going on for over a year but really got legs in Sept. Should we expect then a cumbersome piece of legislation that will repulse capital from US shores in April?